Risks in China stimulus

Opinion: China’s central bank no longer holds all the cards

HONG KONG (MarketWatch) — The catchall response to worries about China’s credit-bloated economy is don’t worry, the government controls the money, and with it, the ability to fix or patch-up any problems. That means talk of a Lehman-style financial crisis, a Minsky moment or a property implosion are all rather far-fetched, as Beijing simply won’t allow it.

Shutterstock/Dmitry Kalinovsky

Indeed, last week it was very much business as usual as a mini-stimulus was announced to shore up flagging growth. This will see more affordable housing being built, more railways, as well as a tax cut for small businesses.

At the same time, guidance from China’s central bank was unequivocally reassuring. The People’s Bank of China (PBOC) released a brief statement after its quarterly policy meeting saying economic conditions are in a “reasonable range,” though the economy faced complicated situations. It also reaffirmed a commitment to keep the exchange rate at an “appropriate level,” while adding that domestic price levels are basically steady.

This sanguine outlook is a contrast to red flags at various agencies, from the IMF to the Bank of International settlements, about China’s dangerous build-up of credit, now estimated at over 200% of GDP.

Such warnings are nothing new perhaps, but the difference this time is that the PBOC no longer controls all the money.

It has become increasingly clear just how much foreign capital China has borrowed, despite its closed capital account. And this foreign capital is getting edgy as the yuan
USDCNY, +0.0000%
weakens and markets brace for further Fed tapering.

According to one estimate by the Bank of International Settlements (BIS), foreign credit to China has more than tripled over four years, rising from $270 billion to $880 billion in March 2013. Much of that lending has come through Hong Kong and Singapore. Brokerage Jefferies estimates that Hong Kong’s financial system has become linked to an “invisible carry trade” with a parabolic surge in lending to mainland China. Since 2009 Hong Kong banks have lent almost $400 billion.

China finds itself in this seemingly exposed situation as an unintended consequence of a piecemeal approach to financial reform: In parallel with pushing yuan internationalization with foreign deposit accumulation and trade finance, China also effectively deregulated interest rates at home by allowing the shadow-banking sector to explode.

At a time of aggressive quantitative easing in the U.S., China proved a hugely popular destination for global liquidity seeking yield enhancement and a stable currency. This has given birth to a yuan carry trade, with everyone from Chinese corporates to exporters and investors joining in.

The upshot is that China’s investment boom has become a function of external dollar funding.

China’s central bank will find this liquidity harder to control. Its master will be market forces, be it the impact of tapering by the Fed or the risk-on/risk-off trade.

This degree of dependence on external dollar funding also means China needs to tread carefully as it experiments with greater exchange-rate flexibility.

The BIS has warned that China’s dollar borrowing has created a risk situation comparable to the Asian Financial Crisis in 1997-98, when foreign-denominated borrowing and falling currencies triggered debt implosions.

This means the PBOC has to strike a balance between curbing excessive inflows and triggering mass outflows.

Cashless credit: China’s rising risks

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As China's economy slows, companies are increasingly relying on acceptance drafts, a virtual currency, to get by.

China’s currency has now fallen about 2.8% against the dollar since February. This move may have broken the belief that the yuan was a one-way-upward bet, but now its value is under a lot more scrutiny in case of further weakness.

The PBOC is in a tight spot. If hot money flows do start heading for the exits, authorities would need to sell down foreign-exchange reserves and tighten domestic liquidity to support the currency.

This would be a difficult decision to contract liquidity when the economy is already slowing. According to Daiwa Research, if push comes to shove, authorities will let the currency weaken rather than allow liquidity to tighten.

For investors, perhaps what they need to ask is where will China’s yuan head as market forces begin to exert themselves?

The traditional trade-off with continued monetary expansion is that adjustment comes through price increases. The PBOC says in its recent commentary that prices are basically stable.

Yet it is hard to ignore the huge price increases in China in recent years. Be it commodities such as corn, sugar, wheat or iron ore, to the prices of fast food, China’s inflation is now increasingly outpacing inflation in other major markets. Hong Kong is bursting at the seams with mainland Chinese day-trippers shopping for cheaper basic necessities.

One explanation is China’s real currency value (adjusted for inflation) is now considerably too high. The question remains — how long can the credit party keep going? China’s foreign borrowing and financial deregulation means that decision will no longer just be up to its central bank.

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